CHAPTER 7 Money Markets

Overview of the Money Market Short-term debt market - most under 120 days. A few high quality borrowers/issuers. Many diverse investors. Standardized securities -- one security is a close substitute for another. Copyright© 2008 John Wiley & Sons, Inc.

Overview of the Money Market (concluded) Good marketability - secondary market. Large, wholesale open-market transactions. Many brokers and dealers are competitively involved in the money market. Physical possession of securities rarely occurs - centralized safekeeping. Copyright© 2008 John Wiley & Sons, Inc.

How does money markets work? It consists of collection of markets, each trading in a specific financial instruments. There is no formal organization for money markets. The main activity of money markets are dealers and brokers who specialize in one or more money market instruments, and all the market participants are linked electronically. Money market transactions are called open-market transactions because of their impersonal and competitive nature. The center of the money market transactions are the trading rooms of dealers and brokers. Copyright© 2006 John Wiley & Sons, Inc.

Economic Role of Money Market (MM) The most important economic function of the money markets is to provide an efficient means for adjusting the liquidity positions. They allow economic units to bridge the gap between the cash inflow and outflows, thereby solving the liquidity problems. The money market is a market for liquidity Liquidity is stored in MM by investing in MM securities. Liquidity is bought in MM by issuing securities (borrowing). Provides a place for Fed’s reserve transactions (open market operations). Copyright© 2008 John Wiley & Sons, Inc.

Characteristics of Money Market Instruments Low default risk. Short maturity. High marketability. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills Characteristics Issued by the government to cover current deficits and to refinance maturing government debt. Sold on discount basis. Maturities up to one year. Issued in large denominations and minimum denomination is $1000 for individual investors. Considered free of default risk. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Treasury Bills Yields The difference between the purchase price and the face value of the T-bill is the investor's return. The investor's return is used in mathematical formulas to determine the yield on T-bills. One formula, the bank discount yield method, takes into account the return as a percent of the face value of a T-bill, rather than its purchase price. Since the purchase price is typically less than face value, the discount method tends to understate the yield. An alternative formula, called the bond equivalent yield method, also can be used to calculate the yield. Unlike the discount yield formula, the bond equivalent yield method, relates the investor's return to the purchase price of the bill. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills Pricing Treasury Bills Treasury bills are priced on a bank discount rate basis, a traditional yield calculation. The bank discount rate, yd , is: Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Example What is the discount yield for a 182-day T-bill, purchase price of $9,659.30 and $10,000 face value? Discount yield = [(10,000) - (9,659.30)] / (10,000) * [360/182] Discount yield = [340.7 / 10,000] * [1.978022] Discount yield =0 .0673912 = 6.74% Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Using the bank discount yield, what is the price ,if the face value is 10,000,discount yield is 6%,maturity is 180 days. Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. U.S. Treasury Bills T-Bill yields is reported on a bond equivalent basis where the discounted price is the denominator and 365 days is used: Copyright© 2008 John Wiley & Sons, Inc.

Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7 You are given the following data: Face price = 10,000, buying price = 9760, days to maturity = 100. what is the yield on a bond – equivalent basis? Solution YBE = [(Face Value - Price)/Price] x [(365/Days to Maturity) ] x 100% YBE = [(10000 – 9760) / 9760] [365 / 100] [100%] = (0.025 )(3.65)(100%) = 8.9% Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7

Copyright© 2006 John Wiley & Sons, Inc. Using the bond equivalent yield, the price is P0 = Pf [1+(ybe* n )] 365 Pf = Face value Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Assuming a face value of $10,000, what is the price of a T-bill with 161 days to maturity if its bond equivalent yield is 1.99 percent? Solution: The price of the T-bill, is: Copyright© 2006 John Wiley & Sons, Inc.

Repurchase Agreements (Repo) DSU sells short term securities (most frequently are T.Bills) with the agreement that the DSU will buy these securities back later at a higher price these securities. Repo can be viewed as a loan that is secured with the short term securities(securities serve as collateral). Difference in prices is interest It is a source of funds. The interest rate on a repo is lower than the fed funds rate, since it is backed up by a security. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. Bank Investment – Reverse Repo SSU purchase T.Bills with the agreement to sell them back to the original seller at a higher price. Smaller banks are able to invest excess liquidity in a secured investment. Copyright© 2006 John Wiley & Sons, Inc.

Repurchase Agreements (concluded) They are used to shorten the actual maturity of a security to meet the needs of the borrower and lender. E.g. If you want to invest for only 3 days, you can buy T. Bill and sell it after 3 days but this will involves price risk if the interest rate changes during this 3 days, another alternative is invest in 3 days repo, eliminating all price risk. Banks participate in the repo market to secure funds to meet temporary liquidity needs as well as lend funds when they have excess reserves. Copyright© 2008 John Wiley & Sons, Inc.

Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7 The formula for the repo yield (yrepo) or interest rate is: Where Prepo = repurchase price of the security, which equals the selling price plus interest. P0 = sale price(repo)/purchase price (reverse repo) of the security. N = number of days to maturity. Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7

Copyright© 2006 John Wiley & Sons, Inc. Repo yield The formula is the same for both the repo and reverse repo. E.g. A bank agrees to buy T-bill from a corporation at $1,000,000 and promises to sell them back at $1,000,145,after 3 days. This is reverse repo $1,000,145 - $1,000,000 * 360 $1,000,000 3 =1.74% Copyright© 2006 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. Commercial Paper It is a short term, unsecured promissory note issued typically by large corporations to finance their working capital needs. Sold at a discount from par. The main reason for issuing them is to achieve interest rate savings as an alternative to bank borrowings. Large denominations -- $100,000 and up. It is unsecured promissory note as the issuer does not pledges no assets to protect the investors in case of default, as a result they are issued by high-quality(high credit rating) corporations. Copyright© 2008 John Wiley & Sons, Inc.

Commercial paper Yields(calculated exactly as T.Bills Yields). The discount yield and the Price using the discount yield : Copyright© 2006 John Wiley & Sons, Inc.

Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7 The bond equivalent yield (ybe) and price on bond equivalent yield basis: Where Pf is the face price, P0 is the purchase price and n is the number of days to maturity. Dr. Hisham Handal Abdelbaki - FIN 221 - Chapter 7

Copyright© 2008 John Wiley & Sons, Inc. Bankers' Acceptances Time draft - order to pay in future. Banker acceptance is a time draft, where the bank accepts the responsibility to repay the face value at maturity to the holder of the time draft. Therefore, it is a direct liability of bank. Mostly relate to international trade. Secondary market - dealer market. Standard maturities of 30, 60, or 90 days -max of 180. Copyright© 2008 John Wiley & Sons, Inc.

Tracing a Banker’s Acceptance Transaction Copyright© 2008 John Wiley & Sons, Inc.

Creating a Banker's Acceptance 1.Importer initiates purchase from foreign exporter, payable in future. Importer needs financing; exporter needs assurance of payment in future. Importer's bank writes irrevocable letter of credit for exporter Specifies purchase order. Authorizes exporter to draw time draft on bank. 2.Once the bank authorize the time draft, it send it to the exporter. 3. Once the goods are shipped, the exporter transfer the documents and the time draft to its local bank. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. 4. The exporter’s bank will pay the exporter immediate cash, but of a discount amount and the exporter becomes out of the picture. 5. The exporter bank will send the time draft and all the documents to the importer bank, who will accept the draft. 6.At maturity, the importer bank will pay the exporter bank the face value of the time draft. 7. The importer is responsible to pay his bank the amount at maturity. Copyright© 2006 John Wiley & Sons, Inc.

Creating a Banker's Acceptance (concluded) Note: If the exporter bank doesn’t want to wait until maturity to get the money, it can sell the time draft but will receive a discount amount. If the importer doesn’t pay its bank, the importer bank still has the liability to pay the face value to the holder of the time draft at maturity. Copyright© 2008 John Wiley & Sons, Inc.

Advantages of a Banker Acceptance: Exporter receives funds promptly and avoids any delays. Exporter eliminates foreign exchange risk, because a local funds pay in domestic funds. Importer's bank guarantees the payment. Copyright© 2006 John Wiley & Sons, Inc.

Money Markets Participants 1. Commercial Banks: Most important participant(either as buyers or sellers) in the MM as they are involved in Treasury bills. Bankers' acceptances (from other banks). Federal Funds. Repo and reverse Repo. Commercial papers. Due to fluctuations in loans and deposits banks need MM securities to provide sources and uses of liquidity Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2008 John Wiley & Sons, Inc. 2. FED (Central Bank): MM securities are the major asset category of the Fed. Open-market operations (buying and selling of MM securities by Fed) is the primary tool for implementing monetary policy. 3.Dealers: They are also important participants, based on their function as market makers where most of them specialize in one or two MM instruments. Copyright© 2008 John Wiley & Sons, Inc.

Copyright© 2006 John Wiley & Sons, Inc. 4. Corporations: They use money market instruments mainly for liquidity issues. If the corporation is large enough, then it may find issuing commercial paper cheaper than short term borrowing from banks. They also use banker acceptance for international trade transactions. Copyright© 2006 John Wiley & Sons, Inc.